Currency market: Fix the rules. Avoid a trade war.

ByDavid R. FrancisOctober 22, 2010

Finance ministers and central bank governors attend a G20 meeting in Gyeongju, South Korea, Oct. 22. A major focus of the meeting is how to fix the currency market to bring the world economy back into balance.

The world needs new rules to keep nations from manipulating their currencies to get an export trade advantage. If rules don't get written, today's escalating trade frictions could heat up into a debilitating trade war.

That's the concern of some economists looking at the massive balance-of-payments deficit of the United States (heading toward $500 billion this year) and the huge trade surpluses of China. China's surprise quarter-point rise in interest rates Tuesday, which makes its yuan more attractive, could raise its foreign-exchange value. That would please the US. But finance ministers and central bankers of the G-20 group of nations are meeting Friday in South Korea because more adjustment is needed in the currency market to bring the world economy back into balance.

When those rates no longer reflected reality, those nations came together again in 1973 to craft the Smithsonian Agreement, which in effect gave the US a small devaluation of the dollar. President Nixon hailed it as "the greatest monetary agreement in the history of the world" (a statement your correspondent missed because, having wandered outside Smithsonian Castle, he got locked out when Nixon suddenly arrived for his press conference.)

Nixon's evaluation didn't prove true. The world's greatest monetary agreement lasted only 14 months. The fixed exchange rate system broke down, giving way to a "floating" system where the price of the dollar and other major currencies was set largely by supply and demand on foreign-exchange markets. The greenback promptly lost 20 percent, which helped rebalance world trade.

The Smithsonian deal created a troubling legacy: Developing countries weren't covered by the currency agreement. Most of them continue to fix their foreign exchange rates by intervening in the market.

Some nations – notably Japan and, later, China – exploited that loophole by keeping their currencies artificially low to boost exports and their industries. In 1985, the Plaza Accord negotiated by the US, France, West Germany, Britain, and Japan put an effective end to Japan's currency manipulation. By 1987, the dollar had lost 51 percent of its value against the yen, making Japanese exports much less competitive.

Mr. McMillion says the yuan is 60 to 70 percent undervalued vis-à-vis the dollar on the basis of purchasing-power parity. But he doubts the Obama administration will do anything substantial about it. Last month, the House passed a bill giving the US Department of Commerce power to assess levies on Chinese imports if it labels Beijing's currency practices an unfair subsidy. The Senate is unlikely to act on the House bill before the midterm election. For months, the White House has pressed China to revalue its currency higher, with only minor success at this writing.

Does that portend a trade war or a competitive batch of currency devaluations to stimulate exports? Probably not, guesses Mr. Williamson. That would hurt all participants economically. And "it's not obvious who would suffer most," he adds.

Global trade flows are recovering from their decline in 2009 during the Great Recession. They are likely to grow 13.5 percent this year, forecasts the World Trade Organization in Geneva.